PMC Weekly Review - January 30, 2015

A Macro View – Plunging Oil Prices

Largely due to the price wars among major world oil producing countries, the crude oil price has tumbled more than 50% since last summer. The magnitude of the drop within such a short period is astounding and has caused great confusion regarding its impact. How will it affect different sectors and companies? Is it overall a good or bad thing for investors?

There is no doubt that plunging oil prices is a disaster for the energy sector. Hailed and embraced by many as a revolutionary growth sector for decades to come in recent years, the sector may suffer as much as the technology sector experienced during the aftermath of the explosion of dot com bubble. However, the damage might not be contained to the energy sector, currently only 8% of the S&P 500 Index. Industrial companies that supply equipment to energy companies may suffer, financial companies that lend money to the energy sector may suffer, lodging and leisure companies that serve mostly the energy companies may suffer, etc. Some quintessential American industrial companies have already mentioned their exposure to the energy sector as a source of disappointment in their recent earnings release and more may come if oil prices keep plunging or simply stay at current levels.

There is no doubt either that plunging oil prices should boost consumer spending and thus the companies could benefit from rising consumer demand. However, compared with the damage to the energy companies that is swift and relatively easy to quantify, there is a delayed effect on consumer behavior and it is far more challenging to quantify the benefit. Corporate America, especially the energy companies, is the most capitalist and efficient entity on earth. Energy companies essentially drill for profit/money not for oil and they have already reacted to plunging oil price through merger & acquisition, cut in spending and mass layoffs. Unlike Corporate America, consumers do not react to oil prices in real time. Just because a consumer saves $100 last month on gasoline does not mean they will “pre-spend” $1,200 projected savings of next year or even spend $100 more next month. The average consumer probably has not figured out the amount of the savings or does not even bother to do so yet. Plus, they might be skeptical on how long oil prices will stay low. It takes time for consumers to change their spending behavior and boost their spending even if they are convinced that low oil prices are here to stay.

It is even trickier for companies that may potentially benefit from rise in consumer demand to figure out the exact benefit. Consumer discretionary companies in theory are the biggest beneficiaries of plunging oil prices, as consumers can spend their gas savings on things like restaurants, clothes, etc. However, this is also a very competitive sector and gaining advantages over their competition is far more important than how to benefit from macro factors, such as lower gasoline prices. That is why while energy companies and other potential “victims” of plunging oil prices are busy slashing their earnings projections, very few potential “beneficiaries” advertise their good fortune.

In conclusion, the damage of plunging oil prices to the affected companies is generally front-ended and relatively easy to quantify. The potential benefit is more back-ended (the time lag effect) and difficult to discern. While low oil prices are a net positive for the U.S. economy and companies, especially in the long run, the sudden change is likely to cause confusion and turmoil in the short term.

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